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AS/AD Model The x-axis represents quantity as in microeconomics, but OVERALL quantity in an economy (real GDP). The y-axis represents the overall price level, not just price of specific item. This is the most common graph that shows overall (macroeconomic) activity.

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AGGREGATE DEMAND (AD) Total amount of goods and services demanded in an economy at a specific point in time and at a prevailing price level.

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Aggregate Demand Downward-sloping curve Inverse relationship between price level and real GDP. This implies that people (consumers, firms, governments, and net foreign purchases of U.S. goods) will want to purchase more as the overall price level falls. Why??? There are 3 reasons…

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Aggregate Demand: Wealth Effect As prices fall, people feel like they are wealthier. Because their money can go further, people will tend to buy more (C ↑) AD = C + I + G + (X-M)

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WEALTH EFFECT Perception that wealth has increased, resulting in an increase in consumption, C.

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Aggregate Demand: Interest Rate Effect As prices fall, this increases the amount of money circulating, which drives down interest rates. People will buy more items that require loans, like cars, houses, appliances, and furniture – durable goods (C ↑). Businesses will also take advantage of lower rates and invest in their companies (I ↑). AD = C + I + G + (X-M)

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INTEREST RATE EFFECT As interest rates fall, consumption increases due to the decrease in the cost of borrowing; as a result, purchases and business investment (Consumption, C and Investment, I, respectively) both increase.

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Aggregate Demand: Exchange Rate Effect As prices in the U.S. fall, our goods become relatively cheaper to foreigners (exchange rate falls). Foreigners buy more from us (X↑), and we buy less from other countries (M↓). AD = C + I + G + (X-M)